FILED JUL COURT CLERK'S OFFICE - OKC CORPORATION COMMISSION OF OKLAHOMA BEFORE THE CORPORATION COMMISSION OF OKLAHOMA

Transcription

1 BEFORE THE CORPORATION COMMISSION OF OKLAHOMA IN THE MATTER OF THE APPLICATION OF ) OKLAHOMA GAS AND ELECTRIC COMPANY ) FOR AN ORDER OF THE COMMISSION ) CAUSE NO. PUD AUTHORIZING APPLICANT TO MODIFY ITS ) RATES, CHARGES, AND TARIFFS FOR RETAIL ) ELECTRIC SERVICE IN OKLAHOMA ) Direct Testimony of James M. Proctor on behalf of Oklahoma Gas and Electric Company FILED JUL COURT CLERK'S OFFICE - OKC CORPORATION COMMISSION OF OKLAHOMA July 28, 2011

2 James M. Proctor Direct Testimony Q. What is your name and business address? 2 A. My name is James M. Proctor. My business address is 5555 West Sixth Street, No. Q5 3 Lawrence, Kansas Q. By whom are you employed? 6 A. I am a self-employed consultant. 7 8 Q. On whose behalf are you providing 'testimony? 9 A. I have been retained by Oklahoma Gas and Electric Company to provide expert 10 testimony on the Company's behalf What is your education and experience? 13 I have a BBA from Washburn University with concentrations in accounting and 14 mathematics. I also have an MBA from the University of Kansas with concentrations in 15 finance and operations research. 16 I have approximately ten years experience in the regulation of public utility companies 17 for two state utility commissions. In addition, I have approximately seventeen years 18 experience as a consultant to state regulatory agencies, independent power developers, 19 diversified traders and marketers of energy and other products, and regulated utilities and 20 their non-utility subsidiaries or affiliates. 21 My experience working for state regulatory commissions includes being the Director of 22 the Public Utility Division of the Oklahoma Corporation Commission and the Chief of 23 Accounting and Financial Analysis for the Kansas Corporation Commission Have you testified before this Commission previously and had your credentials 26 accepted? 27 Yes. I have testified before the Oklahoma Corporation Commission on several occasions 28 and my credentials were always accepted. 1

3 I Q. 2 A. n 4 What is the purpose of your testimony in this proceeding? I am supporting the working capital included in the pro forma rate base for Oklahoma Gas and Electric Company ( OG&E or C ompan ) The components of working capital include cash working capital, net pension and benefit asset ("net PBA), materials and supplies inventory, coal inventory, natural gas inventory, regulatory assets and liabilities, fuel oil inventory, prepayments and customer deposits. My testimony will explain ratemaking principles related to the test period analysis, rate base, rate of return on rate base, and measuring a utility's working capital requirements. Then, I will discuss, in detail, five of the working capital components included in the Company's rate base for the test year ending December 31, Those five working capital components include cash working capital, the net PBA, materials and supplies inventory, coal inventory and natural gas inventory. The remaining components of working capital are discussed in the final section of my testimony. My discussion of these working capital components includes describing the role and measurement of the specific working capital components and illustrating the impact to OG&E's revenues and earnings should the Company not receive the ratemaking treatment recommended in my testimony. I will not discuss the remaining components of working capital here in as much detail because those components either do not involve adjustments or the adjustments are not material. However, the concepts I discuss regarding the measurement, and inclusion of working capital in rate base, generally apply to these other components. How is your testimony organized? My testimony is organized in the following eight sections: Section I.: Role of Working Capital in the Ratemaking Process Section II: Utility Ratemaking Concepts Regulatory Test Period Analysis Fundamentals - Principles of Rate Base/Rate of Return Regulation - Methods for the Measurement of Working Capital Section III: Cash Working Capital Elements of Cash Working Capital 2

4 Objectives for the inclusion of Cash Working Capital Basis of Recognizing and including Excluded Components Section IV: Net Pension and Benefit Asset Section V: Materials and Supplies Inventory Section VI: Coal Inventory Section VII: Natural Gas Inventory Section VIII: Other Working Capital Regulatory Assets and Liabilities. Fuel Oil Inventory Prepayments Customer Deposits SECTION I: ROLE OF WORKING CAPITAL IN THE RATEMAKING PROCESS Q. Generally, what is the role of working capital in ratemaking? A. Working capital represents the required funds necessary to support ongoing utility operations. In ratemaking, the objective for a state regulatory agency is to estimate and measure the amount of working capital necessary, on average, to sustain the utility over the course of a series of twelve monthly periods. That is, the required level of working capital should represent the amount necessary to meet the working capital needs on an ongoing basis, annually, for the years during which a company's prospective utility rates will be charged. Once that amount of working capital has been quantified, it should be included in the test year rate base and, thus, receive a full rate of return for the company's shareholders. Later in my testimony, I will address the role and measurement of specific working capital components. Lo Why do you believe it necessary to discuss concepts of utility ratemaking in order to explain your working capital recommendations? I certainly understand that the Oklahoma Corporation Commission ("Commission"), Commission Staff ("Staff') and other participants to this proceeding have knowledge of ratemaking concepts. However, I believe the relationship between working capital and 3

5 revenue requirements is widely misunderstood. This problem is particularly true for the cash working capital component of working capital. 4 Q. Why do you believe it is necessary to discuss concepts of utility ratemaking in order to explain your working capital recommendations?? 6 A. Too frequently, commissions have not provided an adequate amount of working capital 7 in rate base to sustain the utility's operations. Failing to provide adequate working 8 capital prevents the utility from having a fair Opportunity to earn its authorized return. As 9 I will discuss later in my testimony, a utility's potential earnings shortfall is probably the 10 greatest with respect to common misunderstandings regarding the cash working capital 11 component of working capital. That misunderstanding has led to regulatory bodies 12 excluding large cost of service components such as depreciation and amortization 13 expense, deferred income tax expense, and net income from a properly designed cash 14 working capital study, thus potentially leaving shareholders with a significant earnings 15 shortfall. Often, the argument provided to support those exclusions is that these 16 components do not involve cash flow expenditures during the test year. That argument 17 will be dispelled later in my testimony. I will clearly demonstrate that the argument for 18 exclusion of these elements from a cash working capital analysis is erroneous and results 19 in setting a deficient rate base causing deficient cash flow and earnings for common 20 equity investors SECTION II: UTILITY RATEMAK1NG CONCEPTS 23 Regulatory Test Period Analysis Fundamentals 24 What is the regulatory agency's responsibility in determining utility rates based on 25 the test period approach? 26 Regulatory commissions are responsible for, among other obligations, fixing rates at just 27 and reasonable levels. These rates should provide the utility with a reasonable 28 opportunity to recover all costs prudently incurred in providing utility service. 29 Recoverable costs include operations and maintenance expenses, depreciation and 30 amortization expense, income and other tax expense and a fair return on investments in: 31 (a) utility plant; (b) other utility assets; and, (c) the working capital required to provide 4

6 I and maintain utility service. The sum of these COStS is usually referred to as either the cost 2 of service or revenue requirement for the utility. ) 4 Q Over what period of time are the recoverable costs measured? A. A twelve month period is used to measure the costs of providing utility service. That 6 period of time is commonly referred to as the test year. Test year measurements may be 7 restricted to historic sales, expenses and investments in rate base. However, in most 8 circumstances utility commissions permit adjustments to the recorded historic sales, 9 expenses and rate base to make the test period representative of revenue requirements 10 going forward after the test year-end. Some commissions may allow test period data to be 11 fully developed through forecasts of revenue requirements. Whichever test period 12 concept is used, the primary objective must be to estimate the level of sales, expenses and 13 rate base representative of those conditions expected during the period new utility rates 14 will be in effect, not for the historic test year Is it possible for a commission to rely too much on historic test year costs for setting 17 prospective utility rates? 18 Yes. Sometimes regulators are too conservative when measuring test year cost of 19 service. Generally, the conservative approach is falsely justified on the presumption that 20 historic costs are actual, and known and determinable. It is believed that the historic 21 costs are, therefore, less speculative than those costs from test periods with either 22 extensive pro forma adjustments or forecasted information. However, those historic test 23 period costs are only actual, and known and determinable, for the historic test year: 24 Remember, the test period objective for establishing utility rates is to develop them based 25 on cost levels representative of the prospective period of time for which those rates will 26 be charged. Otherwise, there exists a mismatch between the historic costs and those 27 prospective costs which will occur. 28 Furthermore, regulatory agencies relying heavily on historic test year cost measurements 29 do not overcome the reality that they are projecting future costs. That is, when a 30 commission sets utility test period costs using largely historic estimates, they are 31 projecting the future will be the same, or similar, to the past. Because it is impossible to

7 avoid projecting costs into the future when measuring the test period cost of service, the regulator should do so implementing certain relevant and determinable cost adjustments to historic measurements to make the test period costs more representative of the time period rates are in effect. Such cost adjustments may require estimating, measuring and including expenses and rate base amounts forecasted. or incurred, after the historic test year. Principles of Rate Base/Rate of Return Regulation What is the most common approach used to determine a utility's revenue requirement? The most common approach used to determine a utility's revenue requirement is the rate base/rate of return approach. This approach involves calculating the recoverable costs, separately, and then adding them together. As mentioned above, recoverable costs include: (1) operations and maintenance expense, (2) depreciation and amortization expense, (3) income and other tax expense; and, (4) a fair rate of return on rate base including working capital. Q. What does the rate of return applied to a utility's rate base include? A. The rate of return represents the weighted-average for the individual percentage costs of capital incurred by the utility to finance its rate base. Commonly, those capital costs include the costs of debt and equity used to fund rate base investment. However, there may be other sources of financing as well. Q. What is the ratemaking objective under the rate base/rate of return approach? A. The ratemaking objective under the rate base/rate of return approach is to set the revenue requirement, i.e., the cost of service, at a level to allow the utility a fair opportunity to recover, through its rates, all prudently incurred expenses and a predetermined rate Of return on the utility's prudent investment in utility plant, other utility assets and working capital. That is, in addition to recovering prudently incurred expenses, under this approach the utility should be allowed the opportunity to recover its debt costs and earn a fair return for its common equity investors for their investment in the utility. In

8 I Q. Should working capital and other rate base investments receive a full overall rate of 7 return? A. Yes. Commissions generally recognize that each investor s dollar prudently invested in 4 working capital. and other rate base items, should earn a full overall rate of return 5 through customers' rates. Now. that full return may be recovered through some 6 combination of current and future rates. 7 For example, the return on investment will be recovered through current rates when the 8 working capital, or other rate base component, is included in the test period rate base 9 used to establish current utility rates. The return will be recovered through future rates 10 when the utility's working capital, or other rate base investment, is authorized to accrue 11 financing costs for capitalization and inclusion in a subsequent test period's rate base. 12 The funding for a utility's investment in plant under construction is the most obvious 13 example of financing costs being deferred for recovery in future rates, that is, being 14 recovered after the constructed plant is placed in service Q. Isn't it common for a utility to capitalize, for recovery in future rates, only the debt 17 financing costs with respect to plant under construction? 18 A. Yes. It is common for utility commissions to only allow debt financing costs, on plant 19 under construction, to be accrued and capitalized for recovery in future rates. Frequently, 20 it is the utility's short-term debt cost that is capitalized during construction, but long-term 21 debt and equity costs are at times capitalized also. 22 Yet, even when only short or long-term debt costs are capitalized, the utility still earns, 23 and recovers through customers' current or future rates, a full overall rate of return on 24 each dollar prudently invested in plant, and other rate base items. This is the case 25 because, even if only short or long-term debt costs are capitalized to construction costs, 26 the remaining debt and equity financing costs incurred to fund the utility's other 27 investments and operations are allocated in greater proportions to current rate base. That 28 is, current rates include equity financing costs that otherwise could have been allocated to 29 construction financing and collected in future rates through recovery of then constructed 30 plant in service. 7

9 I Therefore, as the discussion about capitalized construction financing costs illustrates. each investor's dollar prudently invested in working capital., plant and other rate base 3 items, on average, correctly earns a full overall rate of return through customers' rates 4 either, currently, or in the future. That is, investors are made whole for their financing 5 costs. 6 7 Q. Should regulators take care in deriving the cost of service? 8 A. Yes. It is important for a regulatory body to be diligent in establishing rates. The 9 components of the rate base/rate of return formula should represent the commission's 10 best estimate for the level of costs necessary to sustain utility operations and earnings 11 going forward. If rates set under the formula overstate the sum of the expected costs 12 going forward, the customers will pay higher rates and common shareholders will receive 13 greater earnings. If rates set under the formula understate the sum of expected costs 14 going forward, the customers will pay lower rates and common shareholders will receive 15 lesser earnings. Neither of those outcomes is appropriate, particularly if the difference 16 between estimated and actual costs is substantial Methods for the Measurement of Working Capital 19 Are various approaches used to estimate working capital requirements? 20 Yes. Regulators have employed various strategies for estimating a utility's working 21 capital requirement. For this particular rate case, OGE's working capital includes: cash 22 working capital; prepayments; materials and supplies inventory; fuel inventories; 23 regulatory assets and liabilities; customer deposits; and the net PBA. In developing 24 OGE's working capital needs for these investments, I have employed several different 25 approaches. I will explain the reasons supporting the approaches later in my testimony. 26 However, each different approach is tailored to the specific circumstances affecting 27 respective components of working capital investment Q. What are the various approaches used to determine working capital requirements? 30 A. Generally, regulatory commissions apply some combination of several measurement 31 techniques to estimate utility working capital requirements. For working capital 8

10 n Q A components that involve an inventory, or other utility asset investment balance, such as for fuel, materials and supplies or regulatory assets, techniques include: averaging historic month-end test year balances: using a historic test year-end balance: averaging historic month-end test year and month-end post test year balances: using an historic balance at some month-end after the end of the test year: and, projecting or forecasting balances. A commission may use various combinations and variations of these techniques. But, the goal should always be to select a method that reasonably represents rec1eii levels of investment chrin the neririrl the new rite Will he hroed Determining cash working capital requirements is a more complex matter than for inventories or regulatory asset balances. There are generally three methods which have been traditionally employed by regulatory commissions for measuring cask working capital. Those methods include: 1) a 45-day standard formula approach: 2) a balance sheet approach; and, 3) a lead-lag study. While advantageous for their simplicity, neither the 45-day standard formula nor balance sheet approach is as accurate or comprehensive as the lead-lag approach. Because OG&E prepared a lead-lag study, which I reviewed and believe contains all the correct assumptions and applications, 1 my testimony regarding cash working capital focuses only on the lead-lag study approach and how such a study should be correctly applied in determining cash working capital requirements. Further, since the Staff and other parties to Oklahoma rate cases have not recently proposed either the 45-day standard formula or balance sheet approaches for large investor-owned electric utilities, I find it unnecessary to discuss those methods here. However, much of my testimony will be dedicated to explaining the correct application of a lead-lag study in determining cash working capital requirements. Please illustrate the importance of measuring working capital such that the amount in rate base is representative of prospective needs rather than historic balances. For one reason or another, historic monthly averages or test year-end balances may not be representative of prospective working capital requirements. When they are not representative, but still used for ratemaking, the impact to rates and the utility's earnings 1 The lead lag study is contained in Schedule E-I of the MFR package.

11 can he significant. For example, let's assume a strict historic 2010 test year is used. 2 Under such scenario, some working capital and other rate base components are based on 3 test year average monthly balances and others on test year-end balances. By the time the 4 audit and hearing process is completed, new rates could be expected to go into effect 5 beginning around January or February When 2010 test year-end balances are used 6 for measuring working capital, rates would become effective a full twelve months after 7 the end of the 2010 test year. Also, if rates become effective January 2012, any historic 8 working capital measured based on 2010 test year average balances would be eighteen 9 months old. Such is the case because a 2010 test year average monthly balance reflects 10 the theoretical amount of capital required on July 1, mid-point of the 2010 test year.. 11 When test year-end balances are used for measuring working capital, a similar calculation 12 finds that rates are effective twelve months after test year-end. 13 If the new electric rates are to be charged for two or three years, the potential problem is 14 even more severe. When costs and investment levels remain relatively stable after the test 15 year, the use of historic data, predominantly, serves well when measuring rate base. 16 However, it is not always the case that costs and investments levels remain stable. 17 Working capital requirements for such components as fuel and materials and supplies 18 may vary significantly due to inflation, changes in the required quantity of inventories 19 and changes in the type of assets in inventory. 20 Also, uncontrollable events in conjunction with prudently negotiated purchase and 21 transportation contracts may cause an inventory or other working capital balance to be 22 larger than normal for a period of time. Because such events are uncontrollable, and do 23 occur occasionally, a commission should consider including a return on the additional 24 working capital caused by the uncontrollable event, especially when such event is 25 prudently managed by the utility's management to mitigate harm. A good example of 26 such an uncontrollable event that must be managed by the utility is the coal inventory 27 levels, which will be discussed in detail below When would it be appropriate to measure working capital using average balances? 30 ri Some working capital balances tend to fluctuate through any given twelve month period. 31 For example, materials and supplies inventories tend to be somewhat volatile overtime 10

12 because their use is not constant. This is particularly the case for expensive plant assets in inventory. When working capital balances vary over time, an average of balances may provide a better estimate of the on-going investment for those respective assets However, based on the aforementioned problems of using historic balances, it is necessary to extend the averaging beyond test year-end to capture levels of investment more closely in line with prospective requirements. in certain cases, it may be necessary to forecast or project a balance for working capital amounts when investment in a particular component is increasing Q. When would it be appropriate to measure working capital using period ending balances? A. Some working capital and rate base asset balances tend to increase over time. This is generally indicative of electric plant. Some working capital inventory balances may fluctuate but also increase over time. If working capital assets, such as inventory, are increasing, then it may be appropriate to measure that working capital component at test year-end. As for averaging working capital balances, it may be necessary to measure the period ending balance at a month-end beyond the test year, or use a forecast, to capture levels of investment more closely in line with prospective requirements SECTION III: CASH WORKING CAPITAL N Elements of Cash Working Capital Please define cash working capital. Cash working capital represents the amount of cash funding required to support the operational requirements of the utility for the period between when cash must be spent by the utility in providing its services and when cash is received from customers when those customers pay for their utility service. That is, cash working capital represents that amount of cash, on average, that a utility invests during a specified annual period, through equity or debt financing, in addition to investors' investment in plant and other separately identified rate base assets. 11

13 I Q. Is cash working capital a component of rate base? A. Yes. Cash working capital is included in rate base as a net positive, or net negative amount. That is, when the utility's investors provide the net funding, the return 4 requirement is positive and when ratepayers provide the net funding, the return 5 requirement is negative. Therefore, cash working capital must he measured with care to 6 assure the company receives recognition for cash working capital provided by its 7 investors and the customers receive recognition for cash working capital funded by them 8 through utility rates Q What are the components of rate base? 11 A. Rate base represents the value of investor funded plant and other investments required for 12 providing service to the utility's consumers. Specifically, it includes plant, materials and 13 supplies inventory, fuel inventory, prepaid expenses, regulatory assets and liabilities; 14 miscellaneous customer provided capital and cash working capital. The cash working 15 capital component of rate base includes cash prudently funded by investors in the utility 16 operations that has not been accounted for elsewhere in rate base Q. Should investors be allowed to earn a return on all funds invested in utility rate base 19 including cash working capital? 20 A. Yes. Regulatory economics and law generally require that investors be allowed a fair 21 opportunity to earn a reasonable return on the value of their prudent investment in rate 22 base. Since utility rate base is the amount by which the commission-authorized rate of 23 return is applied to determine pro forma operating income, if the cash working capital 24 component of rate base does not include all cash prudently invested by investors in the 25 utility, the equity investors' actual return will be deficient. 26 Further, because cash working capital is a component of rate base, there should be a 27 return requirement associated with that investment. That rate of return should equal the 28 same overall cost of capital applied to other rate base assets. Keep in mind through, as 29 stated earlier in my testimony, sometimes the return requirement for cash working capital 30 is positive and sometimes it is negative. So, the return allowed for cash working capital 31 should reflect the proper timing sequence between when cash is funded by utility 12

14 1 investors and when cash is provided by customers and this proper timing sequence is 2 determined by a lead-lag study, 4 Q What method of measurement was employed by the Company to measure cash 5 working capital in this cause? 6 FA The Company employed a comprehensive lead-lag study for the test period ending 7 December 31, The major objective of a lead-lag study is to determine the amount 8 of investors' cash invested in the utility in addition to that invested for other rate base 9 components such as net plant. Lead-lag studies must measure lags and leads, consistently, 10 by analyzing all sources and uses of cash Q. What do the terms lead period and lag period refer to? 13 A. The lead period relates to the time period, in days, between recording a cost and paying 14 for such cost. The lag period relates to the time period, in days, between when utility 15 service is provided and when receipt of cash for such services is received from 16 customers. A lead-lag study consists of a comprehensive review of test period 17 transactions to determine an overall net-lag day amount to be used in determining cash 18 working capital requirements Q. Will you provide an example of a lead-lag calculation? 21 A. Yes. For example, if service revenues, based on a weighted-average of revenues, have a day lag period and costs, based on a weighted-average of costs, have a 10-day lead 23 period, the company's recovery of the test period cost of service has a 5-day net revenue 24 lag (15-day lag period minus 10-day lead period). That means investors must fund, using 25 cash working capital, 5 days worth of the test period cost of service. Thus, in this 26 example of the lead-lag calculation, the cash working capital requirement is determined 27 by multiplying the test period total cost of service by 5 (net revenue lag) and dividing that 28 product by 365 (days in a year). The resulting number is the amount of cash working 29 capital that should be in rate base. 13

15 n Are there potentially other cash working capital considerations in addition to the amount calculated from multiplying the test period total cost of service by the net revenue lag and dividing that product by 365? 4 A. Yes. There may be additional sources of cash working capital that have not been fully recognized through the lead-lag study. One must examine a company's test period 6 balance sheet to find these items and then include them as either additions to or 7 subtractions from the cash working capital requirement determined above. The additions 8 to and subtractions from cash working capital consist of assets and liabilities, 9 respectively, which have not either been, but should be, accounted for in rate base or 10 customer provided capital. 11 For example, accrued vacation pay represents an amount for employee compensation not 12 yet paid out in cash when recorded as an expense. Because a company recovers that 13 expense through rates anyway, and a company's lead-lag study does not generally 14 determine a specific lead time for the cash payment of vacation pay, one must subtract 15 the average test period balance of accrued vacation liability from cash working capital to 16 recognize it as customer provided capital. If the company had determined a specific lead 17 time for vacation pay expense, the average test period balance of accrued vacation 18 liability would not have been subtracted from rate base Q. What were the results of the lead-lag study? 21 A. The results of the study indicate OG&E's investors provide the net funding for cash 22 working capital and, therefore, the return requirement in this case is positive. 23 Specifically, the pro forma cash working capital investment is $17,581,155 for the test 24 period Q. What, then, is the adjustment to test period rate base? 27 A. Since OG&E does not assign a value for cash working capital in the test year until it can 28 be calculated from the lead lag study, OG&E has reflected its cash working capital 29 requirement as a pro forma adjustment. The adjustment to cash working capital is shown 2 Schedule E-1 in OG&E's Application, Cause No. PUD , filed July 28,

16 as Rate Base Adjustment No. 11. Specifically. the adjustment increases the test periods balance of cash working capital from $0 to $17, Therefore. the pro forma level 3 of cash working capital is $ VA! VA! Are there certain investments that some parties to the Company's previous rate cases suggested should not receive rate base treatment through cash working capital? Yes. Certain arguments presented before the Commission have supported excluding four components of OG&E's revenue requirement from the lead-lag study in determining the amount of cash working capital investment allowed in rate base. Those components include depreciation and amortization expense, deferred income tax expense, amortization of the accumulated deferred investment tax credit ("ADITC") and net income. The arguments differ somewhat, but each argument draws the same conclusion regarding exclusion of these costs from the lead-lag study. Do you agree with those arguments for excluding depreciation and amortization expense, deferred income tax expense, amortization of ADITC and net income from the lead-lag study? No. As explained in greater detail below, I believe that these revenue requirement components should be considered in determining the amount of cash working capital that should be included in rate base. 23 Q. Generally, what is the impact to OG&E's common equity investors from not 24 including these components in the lead-lag study? 25 A. If depreciation and amortization expense, deferred income tax expense, amortization of 26 the ADITC and net income are excluded from the lead-lag study, OG&E's common 27 equity investors will be denied a fair Opportunity to earn a return on a portion of cash 28 working capital funding the electric operations of the Company. Each of these 29 components represents a cost that a utility uses cash to fund. Since investors provide the 30 cash to pay for such costs, they are entitled to a return on their investment unless such 15

17 I costs are shown to be imprudent providing benefits to non-utility businesses: or funding non-jurisdictional operations of the Company. 3 4 Q. Specifically, in terms of dollars of rate base, revenues and earnings, how much could 5 the Company be denied if these costs are incorrectly excluded from the lead-lag 6 study? 7 A. In Exhibit JMP- 1, attached to my testimony, 1 include a calculation for the amount of rate 8 base, revenues and earnings, the Company could be denied if these costs are incorrectly 9 excluded from the lead-lag study. In that exhibit, the Commission can see that the pro 10 forma rate base, as filed by OG&E, could be deficient by $51,452,366. Assuming 11 OG&E's proposed return on equity, weighted-cost of debt, capital structure, and the rate 12 base deficiency above, the annual short fall in cash revenues and after-tax cash flow to 13 OG&E's shareholders could be $6,506,306 $3,984, us How will the remainder of your testimony regarding cash working capital be 16 organized? 17 FA I will separate my discussion into three sections. They are: (1) a conceptual overview of 18 cash working capital and the objective for including cash working capital in rate base; (2) 19 the basis for including depreciation expense, deferred income tax expense, amortization 20 of ADITC and net income in a properly designed lead-lag study; and, (3) specific 21 comments addressing the flaws inherent in arguments contesting consideration for and 22 inclusion of cash requirements attributed to depreciation expense, deferred income tax 23 expense, amortization of ADITC and net income in cash working capital and, thus, in rate 24 base Objectives for the Inclusion of Cash Working Capital 27 Q. Why is cash working capital included in rate base? 28 A. Cash working capital is included in rate base to synchronize the value of the total 29 collection of rate base assets with the value of un-recovered cash prudently invested in 30 the utility for a specified test period. That is, it represents an amount of cash investment 31 not yet recovered through customers' revenues, although also not included in other rate 16

18 1 base, or deferred assets, that are separately earning or accruing a return, respectively. 2 Cash working capital is the amount of cash that investors provide the utility, but could fall through the cracks if it is not included in other places in rate base. Cash working 4 capital is therefore included in rate base to ensure that any cash not otherwise reflected in rate base earns a return. Put another way, for the rate base to be correctly measured for 6 specified test period, the cash working capital component must be compatible to (or 7 synchronized with) other rate base items in order to match rate base with the amount of 8 cash invested in the utility's operations Q. If cash working capital is not synchronized with other areas of rate base, what will 11 be the ratemaking result? 12 A. If cash working capital is not synchronized with other areas of rate base, the rate base 13 will not function properly and, thus, earnings will be deficient. For example, if rate base 14 components, such as net plant in service, do not accurately represent the un-recovered 15 investment in utility plant for a given test year, and test year net plant is not adjusted to 16 correct that difference, cash working capital should be provided to correct that difference. 17 Otherwise, the rate base will not match the cash invested, on average, in the utility for the 18 test year Q. Will you please provide an example of that situation? 21 A. Yes. Cash working capital needs to be provided for test year depreciation expense.' This 22 is necessary because the test year-end plant levels in rate base are decreased by 23 accumulated depreciation. Now, at test year-end, the Company has not yet received cash 24 through sales revenues for a portion of the accumulated depreciation removed from rate 25 base. The investors should be provided a full return on that portion of accumulated 26 depreciation, removed from rate base, until it receives the depreciation-related cash 27 through revenues. I will address the cash flow related to depreciation expense in more detail later in my testimony. The discussion of depreciation expense and accumulated depreciation here is simply to provide an example to illustrate the relationship between cash flow, non-cash expense items and rate base. 17

19 I Q. 2 A UN 'A' What is the ratemaking objective behind decreasing plant investment for accumulated depreciation? In utility iaternaking the objective behind decreasing plant investment, for accumulated depreciation, is to not allow a return on plant investment for which investors have already recovered cash through customers' revenues. However, at test year-end, there exists an amount of depreciation expense recorded on OG&Es books, and used to decrease rate base through recording accumulated depreciation, even though that depreciation expense will not yet have been received from the Company's customers through revenues. The cash recovery for a portion of depreciation expense will have not been recovered at test year-end because of the revenue lag. 4 That is, the net plant balance (i.e., plant less accumulated depreciation) included in rate base is deficient. It is deficient by that portion of recorded accumulated depreciation not yet received, in cash, through OG&E's utility rates. Specifically, the un-recovered cash flow, due the Company for its recording of depreciation expense, is incorrectly attributed to the Company's shareholders even though that amount of cash is still in the hands of the ratepayers. How else could the Commission correct this rate base shortfall if cash working capital is not provided? The Commission has two options to ensure that any cash not otherwise reflected in rate base earns a return. The first option is to include cash working capital in rate base. If the Commission does not choose to allow a cash working capital allowance for the unrecovered cash not otherwise included in rate base, the other option is to adjust rate base in some other way. For example, with regard to the above discussion regarding unrecovered test year-end depreciation expense, OG&E could alternatively increase the rate base by decreasing the accumulated depreciation balance accordingly. The decrease to accumulated depreciation should be equal to the amount of depreciation expense for which cash had not yet been recovered through customers' revenues due to the revenue lag. The lead-lag study found that the revenue lag is days. That means that at test year-end days of depreciation expense had not been received fromratepayers' through their payment for electricity services. 18

20 2 Q. 3 A Q A Q. 22 A Basis for Recognizing and Including Excluded What will you demonstrate in this section of your testimony? I will explain the basis and required treatment for including depreciation expense deferred income tax expense, amortization of ADITC and net income in a properly designed lead-lag study. Inclusion of these costs in the lead-lag study is absolutely necessary to match test year cash investment with test year rate base. If these components are not synchronized with other areas of rate base, the shareholders will not receive a return on their full prudent investment in OG&E's Oklahoma jurisdictional electric utility. Do you think your application of the lead-lag study provides a reasonable amount for cash working capital? Yes. I believe the principles employed in the Company's lead-lag study are theoretically sound. In accomplishing that outcome, I have employed the total revenue requirements approach. Under that approach, all components of the revenue requirement are examined in arriving at a reasonable value for cash working capital. All components of the revenue requirement must be examined because all expenses and earnings requirements are directly related to cash expenditures or cash receipts at some point during the provision of utility service. In previous cases have some other parties disputed the Company's approach? Yes. A review of the testimony and pleadings in previous cases finds that certain witnesses have a different opinion regarding the elements of cost of service to be included in a lead-lag study. I will address their arguments in more depth later in my testimony. However, in general, these witnesses feel the study should be limited to costs that involve cash expenditures during the "current period". That approach unfairly excludes part of the Company's full investment in the utility. That is, those witnesses' positions fail to recognize, for example, that un-recovered investments made in previous historic periods should continue to earn a return until the investment has been recovered through customers' revenues. Their flawed reasoning has led them to advocate arguments that have the effect of not recognizing all cash 19

21 I LI A investments outstanding, and caused by the revenue lag. for depreciation expense. deferred income tax expense. amortization of the ADITC, and net income in the lead-lag study. Why do you believe the lead-lag study should include depreciation expense, deferred income tax expense, amortization of the AIMTC and net income? Because the basic reason for including cash working capital in rate base is to compensate investors for investing cash in the Company and these four categories all affect cash flow and relate to rate base investments. In explaining the need for depreciation expense in the lead-lag study, please explain in detail how investors should receive a full return on and recovery of cash invested in plant. An investor in OG&E receives a return on their investment in plant through the Commission including such plant in the Company's rate base. The investor receives recovery of that investment in plant through the Commission including such plant's depreciation expense in the Company's operating expenses. A utility's net plant, and thus rate base, is decreased through recording depreciation expense. At the time depreciation expense is recorded, that means rate base is decreased, even though the prospective recovery of cash flow for such depreciated investment will not have been received until customers' bills are paid. In the interim, the investor continues to fund the un-recovered depreciation expense, and investors should be compensated for the time value of money for that continued investment. In this case, the Company collects cash for depreciation expense through revenues, on average, about days after service is rendered Unless this lag is reflected in the cash working capital allowance, and its related cash investment is included in rate base, that portion of investor supplied cash will not have an opportunity to earn the Company's proposed return during the lag period. To correctly recognize, and compensate investors 20

22 for, the investment related to depreciating plant, the Commission should assign a zero lead time for depreciation expense in the cash working capital calculation. 5 As indicated earlier, if the Commission does not choose to allow a cash working capital allowance for the un-recovered test year-end depreciation expense, it should alternatively decrease accumulated depreciation by the amount of un-recovered depreciation expense at test year-end due to the revenue lag. The Commission must choose one of these options to synchronize the value for the total collection of rate base assets with the value of un-recovered cash prudently invested in the utility for the test year. Q. How else can you illustrate this deficiency? A This situation can be illustrated by discussing a customer deposit in a savings account. Let's say someone had deposited $1,000 in a bank savings account. After 30 days, that customer visited the bank to withdraw $100 from the savings account. The bank confirms the customer's balance at $1,000 then subtracts $100 from the balance, for the requested cash withdrawal, leaving $900 in the account earning interest. However, the bank teller then explains to the customer that she will not receive the $100 cash withdrawal for days and, during that lag period, she will not receive interest earnings on that $100 cash withdrawal. In essence, the customer has to wait the lag period to receive the $100 withdrawal and will only receive interest on $900 of her $1000 investment. The customer should be entitled to the full amount of interest for the full $1000 dollars until the customer receives the $100 withdrawal. To apply this analogy to a utility's cash working capital, a utility's investors make a "deposit" with the utility. They earn interest by accruing a return on their deposit and, as they are paid back (through depreciation expense), their principal balance in the "account" (i.e., the investment in plant) is reduced. It would be unfair for the utility investor to see the principal balance diminished, not earn a return on that diminished balance and have a delay in receiving recovery of the depreciation expense. In assigning a zero lead time to depreciation expense, one recognizes that prior to recording plant investment to rate base the company has already expended cash for that investment. Therefore, no additional lead time is needed when recording depreciation of that plant. That is, the cash related to the depreciation expense was invested in prior periods during construction or acquisition of the plant asset. 21

23 I Q. How should deferred income tax expense be treated in the lead-lag study? 2 A. The treatment for deferred income tax expense is the same as that for depreciation expense discussed above. In determining revenue requirements, the provision for deferred 4 income tax expense is included in expenses and the balance of accumulated deferred 5 income tax ('AD1T") expense is deducted from rate base. Just as is the case with 6 depreciation expense and accumulated depreciation, the ADIT is recorded as a liability 7 upon recognition of deferred income tax expense in the income statement, yet the 8 deferred income tax expense has not been collected from customers, on average, until the 9 end of the revenue lag period. 10 For that interim period of days, continued investor funding exists equal to the un- 11 recovered deferred income tax expense. The investors should be compensated for the 12 time value of money for that investment. That objective is satisfied from including days of deferred income tax expense in cash working capital and, thus, authorizing the 14 Company to earn its authorized return on that cash investment. 15 As for depreciation expense, to correctly recognize, and compensate investors for, the 16 investment related to ADIT, the Commission should assign a zero lead time for deferred 17 income tax expense in the cask working capital calculation. If a cash working capital 18 allowance is not provided here, the Commission must adjust rate base to remove that 19 portion of test year-end ADIT liability related to un-recovered deferred income tax 20 expense Q A Is there any difference between how deferred income tax expense and depreciation expense is treated in the lead-lag study? Yes, there is a slight difference. With depreciation expense, a utility's investors are repaid for their investment previously contained in rate base. With deferred income tax expense, the utility's investor is being "loaned" money from customers to pay future income taxes and, in return, customers are benefiting from greater amounts of ADIT 22

24 (which is a reduction to rate base ).6 2 ljo-%vever, the principle is the same: the cash "loan" received from the customers through the payment of deferred income tax arrives to the Company days after the ADIT 4 has been recorded as an offset to rate base. That is, during the revenue lag of days, 5 the Company's rate base has been decreased for ADIT, but the cash, in the form of 6 revenue, has not been received from customers. Therefore, the Company is paying a 7 return to customers, due to the ADIT offset from rate base, for days, on average, 8 before the cash "loan" is received through customers' revenues Q. How else can you illustrate this deficiency? 11 A. This situation is analogous to a bank loan. Let's assume a customer goes to the bank to 12 apply for a loan of $1,000. The bank approves the loan application with an interest rate of 13 10%, but agrees to disburse the loan, in cash, to the customer in days. However, 14 the bank charges the interest rate of 10% during the revenue lag period of days 15 even though the customer does not have the cash loan yet Q. How should amortization of the ADITC be treated in the lead-lag study? 18 A. As accumulated deferred investment tax credits are amortized, that amount of 19 amortization decreases income tax expense collected through revenue requirements. The 20 correct treatment for the expense offset created from amortizing ADITC is similar to that 21 treatment provided for depreciation expense and deferred income tax expense in the lead- 22 lag study. 23 Unlike the case for recording ADIT, rate base is not adjusted from recording ADITC due 24 to the tax law prohibiting the full benefit of investment tax credits being transferred to the 25 utility's customers. That is, the Company was not required to recognize ADITC as cost- 26 free capital, therefore, its amortization does not increase rate base. 6 Through the ratemaking process, customers receive a "return" on the funds provided through rates, due to the Company's rate base being decreased by ADIT, the accumulated balance of funds not yet paid in cash to the government. That is, absent the Company recovering customer contributed capital in the form of deferred income tax expense, the Company's rate base would be larger, thus requiring a larger return for investors, in future periods, as the Company pays off the deferred income tax liability to the government, the amount of ADIT subtracted from rate base correspondingly decreases and, thus, rate base increases. 23